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Active Management Was Made for Volatile Markets

Every once in a while, the markets like to remind us that they don’t always follow a straight line. From the COVID-19 crisis to the recent taper tantrum from the Fed, there are sometimes shocks to the system. Volatility and investing go hand and hand, and there’s always bumps in the road.

But it turns out that we don’t need to suffer right along with that volatility.

Active management can go a long way in fighting volatility. Thanks to some unique advantages over passive investment strategies, active management is better suited to fighting volatile markets. In fact, active management can play a bigger role in increasing returns, reducing losses and smoothing out our rides during these times.

With the growth of low-cost active ETFs, investors have plenty of chances to reduce volatility in their portfolios.

See our Active ETFs Channel to learn more about this investment vehicle and its suitability for your portfolio.

What Is Volatility?

Turn on any financial news station or read any article on investing and there’s a good chance that the word volatility will be thrown around. But what exactly is volatility? Technically, volatility is the “statistical measure of the dispersion of returns for a given security or market index.” In basic terms, it’s the magnitude of the swings in a security’s price. A security with low volatility is like driving over the desert: flat and smooth. A security with high volatility is like driving over a mountain: steep hills and valleys.

The problem is that volatility has a lot to do with your underlying returns.

Comparing two portfolios – one with high volatility and one with low volatility – underscores how the smoothness of the ride determines returns. For example, portfolio A has low volatility. It never grows by more than 10% per year, but it also never falls by more than 5%. Over a 20-year period, Portfolio A grows by 55%. Portfolio B has much higher volatility. It achieves returns of 40%, but it also sees much greater losses of 35%. The effect is that over the same 20-year period, Portfolio B will see losses. The key is in the compounding and the higher percentage of losses.

Overall, the smoothness of your ride determines your returns.

Active Over Passive

One of the big issues today is that many investors have completely hitched their rides to indexing or passive investing. There’s nothing wrong with buying a vehicle like the SPDR S&P 500 ETF Trust (SPY) or iShares Russell 3000 ETF (IWV). They can form great core holdings.

But they aren’t perfect either. With indexing, you get both the good and the bad. Investors are subjected to the overall whims of the market, and that includes changes and shocks to volatility. Given how most indexes are market cap-weighted, a few stocks can significantly influence their direction and price swings.

But active management can function differently.

For one thing, active managers don’t have to buy all the stocks in an index or in the same weightings as their benchmark. This can help reduce volatility. Secondly, active managers can focus more on dividends. Dividends have long been a great way to reduce the overall volatility of the portfolio. After all, getting 2 to 4% in cash goes a long way to boost returns.

Probably one of the advantages that active management has over passive is the ability to not be 100% invested at all times. Active managers have the ability to sell stocks as they please and flee to cash if they feel like volatility is too high or valuations are too great. However, this is not so with passive indexing. An index fund will own all its benchmark holdings even if stocks are bouncing around or trading triple-digit P/Es. This ability to hold cash can be a great way for active managers to reduce losses and enhance returns for their shareholders.

A recent NAAIM study highlights this factor and dubs it the “buy-and-hold equalizer.” Looking at 70 years’ worth of market data, active managers can actually be on the wrong side of the market nearly 40% of the time and still equal a buy-and-hold return. This is because the ability to flee to cash creates a leverage effect during market upswings. Conversely, the remaining 60% that do get it right end up outperforming during periods of high volatility.

Active ETFs Make It Easy

The win for investors is that the growth in the number of active ETFs makes it easy to add active management to their portfolios. With active ETFs, investors can gain from the volatility benefits of active management with low-cost access. Those low costs, by the way, enhance the overall effect and only strengthen the appeal of using active management in a portfolio.

By adding active ETFs to a portfolio of passive indexed investments, investors can have the best of both worlds. This allows them to reduce volatility, smooth out their rides, enhance returns and, ultimately, produce better long-term results.

For instance, Dimensional US Core Equity Market ETF (DFAU) and Main Sector Rotation ETF (SECT) are actively managed ETFs designed to achieve this purpose.

In the end, active management plays a big part in beating back volatility. The proof is in the data. With many low-cost active ETF choices available today, there’s no reason not to add them to your portfolio.

Use the Dividend Screener to find high-quality dividend stocks.

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Sep 30, 2021